Of the many ways someone can lose their home, loosing possession in a manner which destroys your credit, embarrasses the family and strips your dignity is the hardest. For those who can no longer afford to make their mortgage payments, there are alternatives to bankruptcy or foreclosure. One option is called a "short sale."
However, one thing is clear - the tax implication for each individual's situation is unique so the following discussion is just a starting point. It is best to first consult with your CPA before entering into a short sale or foreclosure transaction.
What is Foreclosure?
Foreclosure is a situation in which a homeowner is unable to make the payments on his or her mortgage, so the lender can seize and sell the property as stipulated in the terms of the mortgage contract. Typically, all or part of the mortgage debt is cancelled at the time of foreclosure. The tax implication the homeowner incurs depends on whether the loan is considered recourse or non-recourse and/or whether an exemption applies. We discuss this distinction below.
What is a Short Sale?
A short sale is where the property owner sells the home to someone the lender has approved and also is willing to accept less than the total outstanding debt owed on the loan secured by the property. The amount of the debt not paid by the borrower is cancelled.
What is Cancellation of Debt Income (CODI)?
If you borrow money from a lender who later cancels or forgives the debt, you may have to include the cancelled amount as income for tax purposes, depending on your circumstances.
It works this way because when you originally borrowed the money you were not required to include the loan proceeds as income because you had an obligation to repay the lender. When that obligation is forgiven the cancelled amount is reportable as income because you no longer have an obligation to repay the lender.
For example, you borrow $10,000 and default on the loan after paying back $2,000. If the lender is unable to collect the remaining debt from you, there is a cancellation of debt of $8,000, which generally is taxable income to you.
Is CODI always taxable?
No. The most common situations when CODI is not taxable involve:
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Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.
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Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total debts exceed the fair market value of all your assets. Insolvency can be fairly complex to determine and the assistance of a CPA is recommended if you believe you qualify for this exception.
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Certain business real estate and farm debts: If you incurred debt directly in the operation of business real estate (renting property is considered a business) or a farm, you may be able to exclude the CODI. These rules are complex and the assistance of a CPA is recommended if you believe you qualify for this exception.
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Non-recourse debt: See below for the definition of non-recourse debt. Forgiveness of a non-recourse loan resulting from a short sale or foreclosure does not result in cancellation of debt income. However, it may result in other tax consequences.
What is the difference between recourse and nonrecourse debt?
One important determination in evaluating the tax implications of these types of transactions is to first determine the nature of the secured debt. Generally there are two types of loans ??" Recourse and non-recourse.
What is Recourse debt?
When you default on a loan, the lender can go after you for the unpaid balance remaining after the property is given to the lender or sold and the proceeds cannot fully satisfy the debt.
What is Non-recourse debt?
When you default and refuse to pay any more on non-recourse debt the lenders only remedy is to repossess the property being financed or used as collateral for the debt. That is, the lender cannot pursue you personally for any unpaid debt beyond the repossessed property.
In California there are statutes which protect the home purchaser against deficiencies. Generally, the Anti-deficiency and One Course of Action laws prohibit secured lenders, under certain circumstances, from going after the borrower for the outstanding balance left after the proceeds from a foreclosure sale have been paid to the lender on the secured debt.
What to do next?
Determining what the best course of action is for your particular situation is not easy. Many factors play into the tax ramifications of your decision. If your loan is recourse, non-recourse; whether you are protected under the anti-deficiency laws or One Form of Action rule all play into whether you have CODI to report. For this reason it is advisable to consult with a qualified CPA and attorney.
